Strategic Fit in Industrial Alliances: An Empirical Test of Governance Value Analysis
Author: Mrinal Ghosh and George John
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Existing research on buyer–supplier ties has ignored firm-specific motivations and their implications on the design of contracts that govern such ties. This exclusion has rendered large variations in the types of contracts used within the same industry unexplainable. In this article, based on Ghosh and John’s (1999, “Governance Value Analysis and Marketing Strategy,” Journal of Marketing, 63 [Special Issue], 131–45) governance value analysis framework, the authors derive a strategizing calculus that considers how contracting parties organize (1) unique resources of a firm, (2) their investments in the relationship, and (3) the contract terms to generate the best possible joint outcomes from these relationships. The authors test the refutable hypotheses using data obtained from 193 original equipment manufacturers (OEMs) operating in three industry sectors (electronic and electrical machinery, heavy machinery, and automotive) with respect to their contracting ties with independent component suppliers.
Based on the results, the authors contend that managers must abandon the naive notion that contract terms should always be written as tightly as possible. Rather, managers should view themselves as “governance value engineers” who add value by engineering appropriate “incompleteness” in procurement contracts that balance (1) expected gains from protecting specific investments, (2) expected gains from making adjustments, and (3) expected losses from exposing existing margins to bargaining over adjustments.
The results suggest that to achieve the right balance, the contract engineer should consider the nature of the expected outcomes and the firm’s resource profile. For example, if the supplier relationship is pursued to generate cost reduction outcomes, all buyers should attempt to engineer complete, albeit complex, contracts featuring fixed prices, fixed designs, and gain-sharing formulas. These terms protect necessary specific investments and motivate suppliers to explore avenues to reduce costs. The authors prescribe all OEMs to pursue cost reduction initiatives with their supply chain partners.
In contrast, while engaging suppliers to pursue quality-enhancing outcomes, contract engineers should negotiate terms that permit design and price adjustments. More incomplete contract terms, such as cost-plus prices, changeable designs, and change orders, are appropriate for facilitating such ex post adjustments. However, there is an added complication in this case. Contracts that are more flexible could expose buying firms with unique customer-side assets, such as brand equity or customer loyalty, to risks from opportunistic appropriation by the supplier. Because these risks are proportional to the strength of the firm’s customer-side assets, firms with high levels of such assets will achieve relatively smaller gains from flexible supplier-side contracts. In such cases, more complete contracts with suppliers must be engineered, even though this sacrifices some quality-enhancing initiatives.
In summary, this research paradoxically suggests that an OEM’s strength in its downstream customer market limits its flexibility on the supplier-side and forces it to sacrifice quality-enhancing initiatives. Such OEMs must move these initiatives in-house rather than attempt to engage independent suppliers.
Mrinal Ghosh has an undergraduate degree in Mechanical Engineering from the University of Bombay and a doctoral degree in Marketing from the University of Minnesota. Since 1997, he has been at the Ross School of Business at the University of Michigan. His research interests include the organization of cooperative interfirm ties in the context of industrial marketing and distribution channels and salesforce compensation. He has published in various journals, including Marketing Science, Journal of Marketing Research, Journal of Marketing, Review of Industrial Organization, and Applied Economic Letters.
George John earned his undergraduate degree in Aeronautical Engineering from the Indian Institute of Technology, Madras, in 1974; his MBA from the University of Illinois, Urbana, in 1976; and his doctoral degree from Northwestern University in 1981. He worked at the University of Wisconsin, Madison, until 1987, and then he moved to the University of Minnesota. His research interests center on the governance of interfirm relationships. He has published on this topic in Journal of Law, Economics and Organization; Marketing Science; Journal of Marketing Research; and Journal of Marketing.
J Marketing Research, Volume 42, Number 3, August 2005
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